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Every contractor wants to make a profit. While it’s not the published objective of many businesses, turning a profit is at the core of every one and is the number one factor in most critical decisions made, behind cashflow. When assessing the direction of your business and deciding what jobs to bid for, or deciding on what rates to charge for your service work, you need to consider the impact of discounting.
The average business incurs many fixed costs such as overheads, rent, power, vehicles and wages, which don’t change irrespective of the amount of work it’s doing. When discounting, very few contractors appreciate the true cost of the discount or how it will impact their bottom line. Costs don’t change, it will still cost the same amount to complete the job but the net revenue will decrease when a discount is given.
Although the same for project or estimated works, if we consider service/do-and-charge work for this example, it can be seen that a business needs to increase the number of service jobs it completes to recover any discount given. You need to work more to cover the reduced profit on each job. When applying discounts, many businesses fail to consider the amount of additional work required to achieve the same profit. The table below illustrates the cost of discounting:
| Gross Profit Margin on Jobs | |||||||
| 10% | 15% | 20% | 25% | 30% | 35% | ||
|---|---|---|---|---|---|---|---|
| Discount Given | 2% | 25% | 15% | 11% | 9% | 7% | 6% |
| 5% | 100% | 50% | 33% | 25% | 20% | 17% | |
| 10% | - | 200% | 100% | 67% | 50% | 40% | |
| 15% | - | - | 300% | 150% | 100% | 75% | |
| 20% | - | - | - | 400% | 200% | 133% | |
Firstly, decide what your current margin is and then look at any discount you may consider offering your customer. Match the two up and you will see the increased percentage of work required to achieve the same level of profit within your business.
Increased competition tends to drive rate discounting, resulting in companies reducing their labour rates in order to attract or retain particular customers, contracts or quotes. The real trick in understanding the table above is to work out the true cost of your employees. Once the “cost per hour” is calculated, the margin you are making on labour can then be calculated.
Many companies are hesitant to raise rates and often believe that they would lose too much business in doing so. Once you understand the cost of employees and what margin you make on labour, the volume of sales you can lose while retaining profit can be calculated as shown in the table below.
| Gross Profit Margin on Service | |||||||
| 10% | 15% | 20% | 25% | 30% | 35% | ||
|---|---|---|---|---|---|---|---|
| Rate Increase | 2% | 17% | 12% | 9% | 7% | 6% | 5% |
| 5% | 23% | 17% | 13% | 11% | 9% | 8% | |
| 10% | 50% | 40% | 33% | 29% | 25% | 22% | |
| 15% | 60% | 50% | 43% | 37% | 33% | 30% | |
It is important to keep in mind that profit margins are key to the success of a business. Seemingly no one is surprised when companies liquidate even though they have been continually winning work. It’s not enough to win work or keep busy – it needs to be profitable.
Written by Gerard Lyons, Business Development Manager – Victoria
The statement around fixed cost needs care when analysing, fixed costs don’t always stay constant . Some fixed cost are semi-variable and are linked to an increase in output. An example is power and telephone which can increase when sales activity increases. Very great example of what to keep an eye on when tendering for work.
Hi Karl,
You are spot on. Overheads change constantly and not understanding overhead costs (down to the per hour level) means you don’t understand breakeven points. It’s a recipe for financial disaster.
You raise a very important point that overheads and overhead cost per hour calculations should be recalculated EVERY 3-4 months, or following major business changes (e.g. purchase of a new vehicle).
One of the processes simPRO have instituted in our pre-implementation workshops is how to calculate recoverable hours and overhead recovery costs. Feel free to send me an email at gerard.lyons@simpro.co if you want a copy of this component of the workshop.
This is an interesting article. Depending on your market and industry, discounting is sometimes essential. Many companies in the construction sector must offer discounts in order to maintain a healthy cashflow. I hope this article is not about justifying the fact that simPRO doesn’t have a discount system for sales invoices.
Hi Sean,
You’re right. I was by no means implying that discounting has no place. My objective was to provide insight into the consequences of discounting and the true cost upon the business. As sub-contractors, our customers need to discount their rates or bid prices in order to win jobs. That’s a reality of being in business. simPRO makes the process very easy. simPRO customers have a clear insight at any point within a job, of estimated, forecasted and actual margin (profit) for the job. From a functional point of view, applying the discount is simply changing the chargeable rate, applying a line-item discount under the rate, including a discount against the cost center or adjusting the margin for the whole job from the project overview tab.
Discounting has it’s place however your suggestion that providing a discount to create a healthy cashflow is not one of them. Your business has a limited number of recoverable hours per year and the rate at which you charge those hours directly impacts the lifestyle (cash and time) you achieve owning the business.
Using the formula provided above – how much work do you need to find/win and complete in order to recover the profit you discounted (gave away)? The hard decision, yet the right one for the future of the business may be to opt out and find other more profitable work.
There are other mechanisms to protect your cashflow.
Discounting should always be a last resort.